Debate Heats Up Over Too Big to Fail Banks

As part of its new Culture of Competition series, the American Enterprise Institute (AEI) hosted a panel recently titled "Too big to tolerate? How to right-size America's giant banks." The program featured three experts who are prominent participants in the debate over the future of the policy known as "too big to fail" — Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City, now vice chairman of the FDIC; Ted Kaufman, a long-time senate staffer who briefly succeeded his boss, Joe Biden as senator from Delaware after Biden was elected vice president; and AEI's Peter Wallison, White House counsel to President Reagan who has a unique perspective on the financial crisis that he purveys at every opportunity, including as a member of the Financial Crisis Inquiry Commission.

Kaufman built his speech around a list of events that together have sparked the movement to take concrete action to reduce the size of the too big to fail banks, which are generally considered to be JPMorgan Chase, Citibank, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley. The share of the gross domestic product accounted for by the largest banks in the United States has grown to 56 percent, from 18 percent in 1985.

A recent statement by Attorney General Eric Holder that the Justice Department takes into account the possible effect on the economy in deciding whether to prosecute the largest banks received a great deal of attention. The Senate Permanent Subcommittee on Investigations held a hearing on the London Whale scandal involving JPMorgan that called attention to the need for stricter risk management practices at the largest, most dangerous banks. Some of the same banks are being investigated over their role in the fixing of the Libor benchmark interest rate to boost profits on derivatives trading.

Kaufman suggested that top bank executives should have to sign more Sarbanes-Oxley-type documents to make it more difficult for them to disavow their involvement in risky practices that could lead to costly bailouts.

Sandy Weill, the architect of the demise of the Glass-Steagall separation between commercial and investment banking, now says the largest banking groups should be broken up. The European Union and the United Kingdom are working on proposals similar to the Volcker rule in the United States, which is intended to reduce the risk posed by proprietary trading activities of banks that are likely to receive government bailouts if they should fail. The Brown-Vitter bill proposes that banks be required to maintain at least 8 percent capital, but for those with assets above $500 billion, the capital requirement would be 15 percent.

Trading activities should have to be moved out of the banks and into separately capitalized subsidiaries in order to insulate the bank from the risk and prevent trading from being subsidized by federal deposit insurance. Kaufman expressed the hope that banks would decide to play a more constructive role in reducing the risk they pose to the stability of the financial system.

Hoenig repeated the theme of a speech he gave last month at the Levy Institute in New York that incentives do matter, that subsidies influence the structure of the financial system and that the present structure of the largest financial institutions makes it difficult for the authorities to control the risk the largest banks pose to the stability of the financial system.

He lamented the fact that the largest banks have been able to take advantage of a lower cost of funds than smaller banks face, access to the Federal Reserve's discount window and FDIC insurance to expand the scope of the federal safety net to encompass their investment banking activities. Meanwhile, the largest banks maintain leverage ratios to tangible capital of 30-50 to one.

Hoenig warned, as Boston Fed's Eric Rosengren did in his own speech at Levy, that five years after the 2008 crisis and three years after the enactment of Dodd-Frank, the fundamental incentives that led to the crisis are still in place, risky activities are still subsidized, the ratings of the largest banks still receive a lift due to their too big to fail status and there would doubtless be enormous pressure to bail them out whenever another crisis occurs.

He proclaimed that mere ring fencing, such as those proposed in the United Kingdom, the European Union and the United States, is not a sufficient response to the threat; the too big to fail banks need to be broken up in the interest of more manageable resolution that would force debt holders to share in the loss. The largest banks should be subject to a leverage ratio that would raise their required capital to at least 15 percent, without the complexity of the risk weightings that have marked the various iterations of the Basel Accords. Such policy changes would increase pressure on the largest banks to reduce their size and complexity.

Wallison highlighted two issues: the funding advantages too big to fail confer on the largest banks, and the danger they pose to financial stability. However, he joins the many critics who fault the Dodd-Frank Act for failing to address these issues, and he specifically challenges the claims of defenders of Dodd-Frank who contend that the "orderly liquidation authority" will effectively contain the risk posed by the too big to fail banks.

Wallison also does not see much promise in various other strategies advanced for dealing with too big to fail. For example, he warns that even if the largest banks were somehow downsized to the vicinity of $500 billion in assets, they could still be viewed as too big to fail and candidates for bailouts in another crisis episode. They still enjoy funding advantages due to the implicit government guarantee that remains in place.

He worries that efforts to trim the scope of their activities, which he derides as the "drifting hulk" model, would leave them unable to compete against securities firms whose share of the corporate finance market has outstripped traditional banking over the last 45 years. Wallison noted that bank lending accounts for only 25 percent of loans to small businesses and 55 percent for real estate, and he attributed the shift in market power to the inherently greater efficiency of securities firms.

This article coincides with a hearing on too big to fail by the House Financial Services Committee and with the introduction by Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., of draft legislation designed to heighten the visibility of the issue of too big to fail by offering proposals, such as stricter capital standards, intended to increase the pressure on bank managers to reduce the size of the largest banks.

Unfortunately, the three speakers on this particular panel, despite their strong interest in the issue, all have some misgivings or idiosyncratic ideas that hamper their effectiveness as advocates for this cause. Nevertheless, the fact that the presentation took place is another piece of evidence that interest in breaking up the largest banks is growing.

However, I see a disparity in the willingness of the respective parties to play for high stakes in the struggle over the fate of the zombie banks and an economy that is also dependent on government support. Highly compensated bank CEOs are willing to bet the economy that they can continue to grow market share, while proponents of bills like Brown-Vitter fret over the prospect of U.S. banks succumbing to the verdict of the market. Decades pass and nothing changes, except the number and size of too big to fail financial institutions, both banks and nonbanks, continue to grow.